In a Field Service Advice (FSA 200049003) published on September 1, 2000, the Internal Revenue Service reveals its plan of attack against the use of family limited partnerships to create discounts to the value of assets transferred to family members as lifetime or testamentary gifts. A number of the Service’s theories, as set forth in the FSA have been at least partially rejected by the courts in the three months since its release. The IRS considered seven "potentially applicable" theories under which to analyze (and attack) the discounts claimed in this transaction. These theories include:

1. The "economic substance" doctrine. Under this theory, a transaction (such as the formation of a family partnership or LLC) is ignored if it has no business purpose apart from tax considerations.

2. IRC section 2703. Section 2703 requires that certain restrictions on the ability to use assets be disregarded in valuing those assets for transfer tax purposes where the assets remain under family control after the transfer.

3. IRC Section 2704. Code Section 2704(b) provides that certain restrictions on liquidation of a family entity be disregarded in valuing interests in the entity for transfer tax purposes.

4. Alternate Section 2704 Analysis. In an alternative Section 2704 analysis, the IRS considered whether a conversion, on the death of the transferor, of the transferred interests into "assignee" interests in the hands of the transferees triggers a transfer under 2704(a).

5. IRC Section 2036. This Code Section, which is applicable only to testamentary transfers, requires inclusion in the gross estate of transferred property, such as LLC interests, over which the decedent retained control at the time of his death.

7. Challenge to the discounts. The Service argues that discounts allowable for liquid assets placed in family partnerships and LLCs should be limited to similar discounts to the net asset value of closed end mutual funds and publicly traded partnerships –generally in the range of 15 percent, instead of the 30-40 percent range commonly claimed by partnership appraisers.

The Service also may assert that transfers of assets to a partnership, of which younger family members already are members, is an indirect transfer of assets to those younger family members and not a transfer of partnership interests. The analysis in FSA 200049003 is a useful roadmap of the IRS’ thinking in the family partnership entity discount area. It may take a decisive defeat on all issues in the courts to force a concession by the IRS, just as it probably will require legislation to enable it to claim total victory.  {Bob Parrish Discussion: For all my clients in a FLP we have discussed this previously.  Please recollect that we have warned each of you about this specific IRS attack a very long time ago.  What we do for you annually is to monitor your FLP for this type of event.  When this event is noted, we adjust the partnership interest of the partner making the transfer.  The partnership interest is increased.  Usually this procedure will be allowed by both the state partnership act and the partnership agreement.  You are encouraged to take two actions - furnish a copy of the partnership agreement to me and counsel with the legal counsel who drafted the agreement to be certain the agreement allows the adjustment of the transferor partner's partnership interest -- if it does not, amend it immediately.}